LCC threats: The Environment, fuel prices, aircraft financing and fees & taxes

And, in passing it is worth noting that the very fact that so many CEOs were willing - directly, not through intermediaries - to express their views on a range of issues is perhaps at the heart of why the LCC environment is so vibrant and innovative. These airlines are led from the top, by individuals wholly committed to continual improvement. In most cases they are preoccupied with the future, largely unencumbered by the baggage of the past. But the key ingredient is almost invariably a passionate commitment.

This extract is from the 'Great Expectations' section of CAPA's Global LCC Outlook report, available for free download at: centreforaviation.com/lcc/report

In the chapter, the report draws together the views of low cost airline CEOs from each region, together with those of industry experts, Professor Michael E. Levine, Dr Julius Maldutis, Professor Nawal Taneja and investor, Bill Franke of Indigo Partners. The chapter attempts to draw together the various threads, linking at the same time the views of airlines from each region. And, despite the varying levels of LCC development and the domestic/international differences, a perhaps surprising level of similarity of outlook emerges.

The Threats facing the LCC sector

There are numerous globally applicable external challenges to the low cost model, such as high fuel costs, government regulation preventing or restraining entry in one way or another, and protectionism generally.

However, regional differences also emerge when airlines and key observers analyse the concerns that may lie ahead.

At a global level, Professor Levine sees generic and industry concerns: "The greatest challenges will come from the intersection of airline growth ambitions and low market-size growth due to a slow recovery from the global recession and from pressures on costs. Low discretionary income and high savings rates will reduce leisure-travel spending and the adaptations necessary to capture more business demand to replace it will increase costs."

And, on specific airline industry complexity, he says, "These pressures will be increased if fuel costs continue to rise and if environmental charges become widespread. As LCCs mature, they will also come under labor cost pressures as seniority increases and attempts are made to unionize growing labor forces."

Julius Maldutis' main concern is over the liquidity of the industry generally and, necessarily, for the US, capacity overload. For Dr Maldutis, finances are a major threat: "Will we see many Chapter 11 filings because of deteriorating liquidity in years to come?" But, for him, "the critical issue over the next three years is what will the airlines do about capacity in 2010 and beyond?", speculating whether "further cuts" are likely. This may be hard; as noted in the main text of this report, domestic US airline capacity in 4Q2009 will already be down by almost 20% against the level of the same time nine years previously. Such declines spell remarkable change. If Dr Maldutis is right, the cuts may be even deeper, unless economic growth returns quickly.

Regional differences in outlook are most marked in Japan, for example, where a very high cost environment (e.g. with limited outsourcing possibilities, mostly provided by the competing full service airlines) means a quite different outlook - it is mostly beset by problems, although change may be afoot under a new government.

The country's aviation system is still dominated by the Tokyo market and its airports and, for the country's highest profile LCC, Starflyer, the "biggest problem for Japanese aviation is landing slot restrictions generated by the air traffic controllers' union. Unless there is a drastic increase of slots in the Tokyo area (Haneda, Narita), this will make it difficult for Starflyer to expand as quickly as planned," says Yasuyushi Motu.

There is another problem too: the chronic condition of the country's number one flag carrier, Japan Airlines. Says Motu, "Another critical issue for the Japanese industry is JAL. As far as stakeholders seek solutions under the current JAL management to keep the carrier alive, it is highly unlikely that JAL can develop its own revival plan. Though the government is intervening to support JAL, a drastic remedy including strategic bankruptcy may well be considered." Meanwhile, the importance of JAL, both as a national icon and as an employer, continues to tilt the overall government attitude to its airline industry.

Environmental issues did not rank expressly as a threat

Interestingly, few of the airline heads places environmental costs and charges as a major threat, at this stage. Only Korean Air's newly formed subsidiary, Jin Air, raised the issue as a key, both as a threat and as an opportunity: "Jin Air believes that environmental issues will be important even for LCCs with their low cost structure...We will use this theme for our marketing to build up our unique brand of premier LCC, focusing on safety first and social responsibility for the future." Jin Air's "Campaign Slogan (is) 'Save the Air', with an environmentally focussed management structure."

The carrier plans actively to engage its passengers in CO2 emission reduction, offering "love the environment coupons", where baggage-free travel will generate "1000 points that will provide a 1000 won discount against future ticket purchases." - an interesting contrast with most current baggage charging strategies. The carrier will also sell "Save the air T-shirts" drawn by famous stars", with profits to "be donated to environmental support groups," and rentals from "onboard games equipment, Sony PSP…will be donated to UNEP to save the environment". Although arguably self-serving, the attraction of this campaign is its goal of engaging passengers fully in the exercise.

Otherwise, perhaps the need to respond to environmental challenges is taken as a given, but Professor Levine expressly ranked it as a high level issue. Once the Copenhagen Conference is over and the dust starts to settle - and as the implications of the European Union's unilateral action begin to gain wider understanding - this will change. Emission caps and a trading system (or more than one) and "environmental taxes" will quickly become part of every airline's furniture.

Meanwhile, there are plenty of other things to exercise the airlines' minds.

Fuel Prices - Enemy #1?

After a gruelling year last year, when fuel prices went far beyond levels anyone expected, a number of LCCs are today prepared to confess frankly that they had been doubting their future. So it is no surprise that fuel features large on the list of threats to the respective airlines. And, despite fears, there can be no certainty that continued slow economic conditions will prevent fuel prices from rising. The US ATA for example has been vociferous in its belief that prices are inflated by money market speculation, not by fundamentals, a view that has many supporters.

For Virgin America, "the biggest challenge for our airline and most LCCs is fuel volatility. Most of us do not have the balance sheets that can withstand large losses for a long period of time," says David Cush. "The ability of the legacy carriers to withstand that has diminished, but has not disappeared. In general, LCCs are much better at enduring the combination of a soft revenue environment and low fuel prices than a strong revenue environment and high fuel prices. If a strong economic recovery means much higher fuel prices, we would rather do without."

This latter sentiment was echoed by his Australian counterpart at Virgin Blue, Brett Godfrey: "Although it would be an economic contradiction, the greatest threat to any airline at present is that the recession drags on and fuel prices shoot up concurrently", although "we don't expect fuel to pick up anything like that spike just before the Global Financial Crisis. But it will increase steadily over time and put more pressure on airlines with ageing fleets and poorer profitability."

Already, for uncertain reasons, oil prices have hovered around USD70, despite severe recessionary pressures, so Godfrey's "economic contradiction" may be a real possibility.

Bill Franke too ranks fuel prices as enemy #1: "Probably the biggest issues for both LCC and legacy carriers over the next three years, a time of liquidity issues for all, will be (i) jet fuel (and how to manage it in an inflationary environment) and (ii) how airlines can finance their aircraft orders in financial markets that are in disarray.

"Higher costs, particularly fuel costs, will stress both legacy and LCC carriers who have limited capacity to hedge. If we see a sustained period of economic malaise coupled with high fuel, several large legacy carriers will face restructuring. LCCs, even successful LCCs, will have to reduce growth as they redirect capital to support their operations."

Fuel prices rank high as a risk among the Middle East LCCs too, but in context up against the array of factors that contribute to make the airline industry such fun. Adel Ali, of Air Arabia: "Whether economies, political instability, fluctuating oil prices, natural disasters and many other factors, it all impacts global aviation. Airlines have to face those challenges and surpass it, its part of what this business is all about." And Sama's Steele…"the greatest threat is the same as others - fuel prices, swine flu, worldwide recession and so on. The greatest challenge is to grow significantly but profitably."

Inevitably, fuel prices are critical to the shape of the industry. For the lower cost carriers, fuel constitutes a higher proportion of costs and LCCs are consequently more sensitive to substantial input price increases. As jet fuel prices went through USD170 a barrel last year and rising, many LCCs were becoming seriously compromised. Peak oil promises to threaten the basic model again, as economies recover.

Even at today's depressed levels of economic activity, oil prices are hovering around USD70, partly on speculation, partly due to production and refining issues. Once prices rise above these levels, there is a steep reduction in the value proposition of LCCs vs full service airlines.

In the short to medium term, there is likely to be a "crunch" period, a revenue vacuum, where the world emerges from recession and a short term surge in demand forces fuel prices to peak, yet consumer demand for travel still lags. This asynchronous scenario - a highly likely one - will be painful for LCC and full service airlines alike.

Then, as activity returns, oil prices threaten to climb progressively higher, until they reach a new plateau of economic activity. At that time, for any carrier whose model is based on maintaining low costs, the disproportionate impact of this external pressure becomes overpowering when fuel prices rise towards the upper range of USD100-200 per barrel.

In these circumstances, even the lowest cost model cannot survive unless substantial yield increases are possible. However, for the lower end of the leisure market, fare increases quickly deter demand, eroding the value of the ultra-low cost model.

If the fuel price inflation is accompanied by strong demand - as it was for a time in 2008 - that demand can help support airlines with a higher yield and service profile. But even these carriers will be stressed and will favour reducing capacity to maintain upward pressure on fares.

During 2009, US network airlines have been thrown a life raft as they accessed the add-on ancillary revenue source. This offered a one-off step change, generating billions of dollars a year. But, even with further increases in the levels of baggage, seating, and other charges, future non-ticket revenue improvements will be only marginal. There will be no easy refuge there.

This USD100+ fuel price scenario, which must be assumed to be set at somewhere between "likely" and "very possible" over the next two years, would therefore arguably favour those airlines which have chosen to navigate a path somewhere between lowest cost and highest yield. An airline which has the ability to generate yields across an interconnected system of domestic and internationals services, but with a low cost base, has a risk-basket which would look to prepare it best for these cost/revenue conditions.

Financing in disturbed financial markets

Bill Franke listed financing as one of his two main headaches: "…new fuel efficient aircraft, with lower initial maintenance costs, will be out of reach except for the most solvent of airlines as financial markets for new aircraft have in large part dried up or, if available (ECA's or a few lessor aircraft), require a substantial airline "equity" contribution or involve high monthly lease costs."

This is an underlying (and usually understated) concern for all airlines at present. One indicator is the disparity noted in this report in the relationship between lease costs for A330s (currently very much in demand, as the B787 replacement of choice) and their purchase prices. At the same time as purchase prices are sliding - despite high demand - lease prices are skyrocketing. Few airlines have the balance sheet to allow them to use more traditional methods of financing. As that process pervades the industry, so aircraft move from being (owned) assets on the balance sheet to (leased) liabilities on the current account, increasing each company's fragility.

Aircraft prices must inevitably suffer continued downward pressure as a conspiracy of reduced demand and tight credit markets cool buyer eagerness. There is also the unknown of several large leasing companies' asset positions in the face of credit limits; liquidating large inventories would create real stresses, further diluting values. But that is little more than academic for airlines, if credit is not available. And, for those which do list aircraft on their balance sheets, decreased values may come home to roost.

Government charges and taxes

Despite the undoubted immense social and economic benefits delivered by the aviation industry, low cost and full service alike, governments typically have underperformed in supporting expansion. In the worst cases, this takes the form of ugly grabs for revenue from the milk-cow, in others simply in underfunding of infrastructure or counterproductive nationalism in airspace. Airports too in many cases come in for criticism especially from low margin LCCs.

In Europe, no airline has been more vocal about airport charges and government taxes than Ryanair. But that is not to say that most other airlines disagree. The impact of taxes and high charges generally has a greater impact on Ryanair's lower fare structure, where the British and Irish "massive taxation" represents 25-30% of fares, according to Michael Cawley. The absence of taxes in, for example, Spain, Italy and Germany, increases the attraction of moving operations from the higher to lower cost economies. This is a feature likely to play out over coming years, when some bases simply become uncompetitive as fares are driven down.

Raymond James' Jim Parker was quoted previously on the threat posed by high salaries in the US. Outside the US he believes, "In Europe, the largest issue is likely to be government passenger tax increases and aircraft user fees including emissions."

Bill Franke observes the tax issue from the other side, as an opportunity that, for example, Ryanair is chasing; namely eventually to convince airports and governments to remove or reduce them, as they become aware of the wider economic advantages of expanded air service. "As Ryanair has proven, other opportunities for LCC's over the next three years include airport fees, maintenance costs and aircraft acquisition, all of which should be in focus as LCCs move to reduce costs and gain market share through lower fares."

Jetstar sees government taxes - along with unnecessary regulatory impediments - as suppressants of Australia-New Zealand travel too. The respective tourism industries would be major beneficiaries of "more cost effective travel between the two countries. Reforms such as a significant reduction in the Passenger Movement Charge (currently AUD47), moves to a single point of clearance, and having both countries support a reciprocal arrangement for once only customer processing for Customs and Immigration, plus the possibility of conducting Trans Tasman flights out of Australian and New Zealand domestic terminals, will deliver greater passenger volumes on this route," says Bruce Buchanan diplomatically.

And in the US, the antiquated airways system is still a major impediment to cost reduction, as well as emission reduction efforts. For Southwest's Gary Kelly, one of the greatest challenges for the airline is the "inefficiencies in our air traffic control system" and the carrier is striving to "achieve more efficient flying by deploying Required Navigational Performance, the cornerstone of the FAA's NextGen Air Traffic Control system, leading to improved OTP and a reduction in fuel burn and carbon emissions."

For European carriers the problem of multiple airways jurisdictions is such an obvious and, for the time being intractable one, that none even mentioned it - but Europe's patchwork of air traffic control regions remains everything that the most Machiavellian mind could devise to undermine efficiencies. This has major cost implications for airlines - in flight time and in delays - and will also in future cause the airlines to be penalised under emission reduction systems.

For India's airlines, the taxation regime defies belief. The scale of taxation of aviation turbine fuel (ATF) in that country makes it surprising that a domestic airline can even contemplate profitability. First of all, oil importing remains a state monopoly, so any profit of the monopoly retailers is already a de facto tax. Then the Central government imposes a customs duty of 10% and an excise duty of 8% (as this is taxed on the gross retail price, it already constitutes a tax on a tax); not to be outdone, each of the 27 states also milks this holy cow - at sales tax levels ranging from 4% to over 30% for each departure.

Cascading taxes at Delhi, Mumbai and Bangalore for example are 20%, 25% and 28% respectively. As these are accumulated on top of the other taxes, the pyramid towers to levels which mean that, with oil prices around USD80 a barrel, fuel represents 40% of total airline costs. In 2008, this proportion was enough to drive most global airlines to the brink of bankruptcy; but for India, this is situation normal. Simply the administrative price of accounting each of these taxes would be enough to run a small airline. There can be no more effective way of capping airline growth.

So when SpiceJet's Sanjay Aggarwal quietly notes "If the Indian government is successful in lowering the taxes on ATF and there is an improvement in airport cost and infrastructure, the industry could get healthier sooner rather than later," there is a history of suffering that would have destroyed lesser industries.

For Kulula/Comair's CEO, Gidon Novak, reduction of "ridiculous airport charges by state owned (airport operator) ACSA" would go a long way to helping viability. Tony Fernandes' practical approach is that there is a joint venture approach needed if growth is to occur: "…we hope that airports begin to see that the full value of LCCs will not happen without them reducing charges to generate a much bigger volume".

Ryanair's Cawley has no doubts about the simplicity of the equation; taxes kill growth: "There is a huge constituency out there. The more we drive fares down, the bigger the market gets."

Threats in transitioning to the "new world"

Inevitably, given the concerns of many observers, the process of moving away from the safer haven of brutal low cost into a more yield-searching mode can be risky. Virgin Blue," seeing the benefits of synergies between our long and short haul operations", seeks to address this challenge by "over-delivering on reliability, network growth and perhaps some more product development. Now, hopefully at the bottom of the economic cycle, and with a successful capital raising under our belt, we are negotiating for a large aircraft order to underpin the rebound and future growth."

Timing is everything. Complacency can be deadly

Ryanair's simple answer to what is the carrier's main threat says a lot about the airline. Apart from the continuing campaign against ugly government grabs which merely tax the industry, the only threat to Ryanair is "believing our own bullshit", says Michael Cawley. That is, listening too hard to the airline's own chest thumping about being the most durable low cost model in town; "we said we were the lowest cost when we floated back in 1997; today our costs are half of that. If we lose our own paranoia (about cost reduction) we will be dead and buried. It's all about lowering costs." External threats? "There is no other!" This is an airline that clearly sees itself as master of its own destiny.

Dave Barger also pinpointed the constant striving as the key issue for his airline: "As JetBlue closes in on its ten-year anniversary, one of the greatest threats and challenges to the firm is complacency." And AirAsia's Tony Fernandes frets, "I spend every waking moment and a few sleeping hours, worrying about where we can save costs."

The genuine low cost model is a restless beast, constantly threatened by the challenges of its external environment, but always seeking a better way to attack the core.

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